Job creation and the carried interest: how venture capital firms are different from hedge funds and buyout funds

House Democrats plan a renewed push to raise taxes on executives at private-equity and venture- capital firms to help pay for year-end economic recovery legislation, a top congressional aide said.

“There is strong support for taxing carried interest as ordinary income and I expect this issue to move forward in the coming months,” Beck said.

Matthew Beck, a spokesman for the House Ways and Means Committee, said the panel will revive an effort to raise the 15 percent tax rate on “carried interest,” a term for the share of a fund’s profit from successful investments that is paid to executives.

That portion of an executive’s pay, now taxed at lower capital gains rates, would be subject to income tax at rates of as much as 35 percent. The top tax rate is scheduled to rise to 39.6 percent in 2011.

A short news clip, but potentially huge implications for the venture capital industry. By way of background, venture capitalists receive a management fee from their investors to run the day to day operations of the firm, much like executives of any business receive salaries each year for running a business. The real “upside” for venture capitalists, though, comes in the form of “carried interest”, i.e. a share (typically 20%) of the profits from their investments in private growth companies. These investments are long term in nature (often 4-7 years) and very uncertain (since most early stage private companies fail). While the owners of most businesses receive their “upside” when they sell their business, generating a gain that is taxed at long term capital gains rates (currently 15%), venture capitalists are typically not able to sell their venture capital businesses but rather earn their upside a little at a time as they (hopefully) generate profits from their investments. Capital gains treatment has historically been viewed as a mechanism for offering favorable tax treatment to long term, value creating investments – the government wants to reward long term investment. This is even more important in the venture capital context, since venture capitalists provide growth capital to the kinds of businesses that generate most of the new jobs each year in America (see our postings entitled “New Businesses Vital to Economic Revival” and “Don’t Ruin Venture Capital“).

The push to start taxing this carried interest at the much higher ordinary incomes rates is a new and disturbing phenomenon. Much of the recent support among certain Democrats in Congress for changing the tax treatment of carried interest is driven by (in some cases understandable) animus toward hedge funds and the mega (billion dollar plus) leveraged buyout funds, some of whose founders have gone out of their way to live lavishly in the public eye ($30 million birthday parties don’t sit well with the average Congressman, particularly when economic times are hard). Whether that criticism is fair or not, the problem for the venture capital industry is that it is being lumped in with the hedge funds and big buyout funds in the proposed legislation. While hedge funds invest primarily in public securities (thus creating no new net jobs) and buyout funds utilize financial engineering and cost-cutting to generate attractive returns on equity as they pay down debt, venture capital funds invest in much earlier stage private companies that have the potential to grow significantly and create large numbers of new jobs while developing new technologies, products and services. These are exactly the kinds of new companies that create most of the new jobs in America every year.

While the media often focuses on the excesses of billion dollar private equity funds, the average venture fund is under $120 million and invests in 15-30 companies over 4-5 years with an average investment hold period of 4-7 years. It is a very long term business that requires a multi-year commitment from the venture capitalist fund managers with very uncertain returns. The venture capital model is built around generating long term capital gains for both the investors and managers of the Funds, and the capital gains tax treatment both recognizes the long term and uncertain nature of the gains created and offers an incentive for talented professionals to focus on (and undertake the high risk associated with) investments in small private growth companies (versus, say, becoming an investment banker or joining a hedge fund). While taxing carried interest at ordinary income rates (currently 35% and scheduled to move higher) arguably may not substantially change the behavior of the managers of a billion dollars hedge fund or buyout fund, it dramatically changes the economic calculus for smaller venture capital fund managers. And, ironically, as smaller venture funds become less attractive to their managers and thus less viable, capital will tend to concentrate in ever larger funds – i.e. the supposed “bad guys” that some in Congress are going after. But the real kicker is that many of the Congressmen who support increasing the tax on carried interest are the same people who complain that there isn’t enough venture capital in their home state being invested in new businesses. By running a stake through the heart of the small venture capital fund model, they will certainly not help to foster new company formation and job creation in their states. We hope they (or the Senate, if the House is a lost cause) realize the dangers to job creation here before it’s too late and step back to think about how the venture capital industry is both different from hedge funds and mega buyout funds and uniquely beneficial to the economy.

For more information on the carried interest issue, check out the NVCA’s take here.